At one time or another, most traders, including myself, have traded by emotion. In coaching sessions and in conversation with many traders over the years, I have seen countless examples of emotional trades and emotional trading. There has been one constant in those observations and it is that those who continue to trade with emotion without some discipline fail. Some of the emails I receive and some of the traders I meet seem to think about buying a stock as they might think about buying a lottery ticket. They go in with a euphoria, or at least excitement that they are going to hit the jackpot. More often than not, they have no exit strategy whatsoever, nor have they considered the risk or the potential reward to risk ratio.
As I set out in my book, "Trade Your Way to Wealth" successful trading involves some self-examination and planning. In the book, I talk about elements to include in the plan and the necessity of having an exit strategy before ever entering a position. Adherence to a simple plan designed for you can really give you a chance to become a better, more successful trader. In the following material, see if you see yourself in any of the examples and then ask yourself how did it work out? A coaching client told me that his failures came from "the little man behind the curtain." He pointed to the back of his head indicating that the "little man" was that voice we have in our heads.
A while ago, I was talking to a guy who told me he bought a stock because he "knew it would go up." Another fellow told me he was buying a stock because he thought it would go up. Neither went up. Each of those traders suffered real losses. What did they do wrong? They approached the trades in "Pollyanna" fashion, "knowing" or believing that the stock would move in a specific direction and ignoring a decision on where they would get out if they happened to be wrong on the direction. Why would they ignore the possibility that their stock would go down? My guess is there were two reasons: first, a case of mild euphoria about the big gain they would get (greed) and second, refusal to recognize, or at least sublimating, an unpleasant emotion -- loss. If we look at things rationally, wouldn't we agree that there is literally no stock that couldn't go down? (If there is, please let me know as soon as possible). Recognizing that any stock can fall in price not matter what we think it will do might lead us to agree that an exit strategy in the event we may be wrong on the direction makes sense. At a rational moment, we can decide exactly where we will cut our loss. If we fail to make that decision ahead of time, aren't we leaving things to our emotions and aren't we more likely to listen to that little voice in our head that says: "it'll come back" even as we go deeper and deeper into the red?
Another example of emotional trading I have seen is the person who grabs a profit as soon as there is one to grab. I've heard a trader say, I took the profit right away because I was afraid I'd lose it. After his exit, the stock moved another $30. The fear caused him to cut his profits and miss another $30 a share. His exit strategy was "the little voice" probably saying something like "Get out of this position, remember the last time you had a profit and you let it turn into a big loss. Don't do that again." Yank, the plug gets pulled. Would a more disciplined approach yield a better result? My guess is in more cases than not, it would. The idea is to cut losses, not profits and to let profits, not losses, run. A predetermined exit strategy such as a trailing stop as I discuss in the book, can keep you in the game through little retracements and market chatter while limiting losses in the event of a reversal. You can create your plan and then execute it so that you simply follow a pre-determined exit strategy. Does that mean you still won't have losses? No. Does it mean that you will always let profits run throughout their whole move? No. It means you are likely to improve your trading by limiting losses and giving yourself a better chance to avoid cutting profits early.
Trading is not about hitting the lottery. It is about having the gains add up to more than the losses. Successful trading involves giving yourself a little edge. The "hot reactors" of trading do not give themselves that edge. They tend to bet it all on black and though they might hit every so often, they are not giving themselves any edge. They are truly the gamblers while the pro traders make themselves the house.
Bottom line is it is your money and your risk so you are entitled to do it however you want. I prefer trying to get an edge, but I really appreciate the hot reactors; they make life a little easier for me.
by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved
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